Friday, January 12, 2018

It’s interesting how often the most memorable and thought-provoking parts of a given discussion are to be found in the tangents away from it.

Yesterday I was in a seminar on the history of economic thought in which we were supposed to be discussing Thorstein Veblen and the American Institutionalists, but toward the end of the session we got side-tracked into a discussion of the modern economy’s use of big data and the way companies gather information to provide targeted advertising. The lecturer somehow tied this into Hayek’s famous explanation of how a free price system efficiently conveys information to economic actors, dispersed and local information which could not possibly all be known to an economic central planner, and hence allows for those resources to be economized in a way that more rationally reflects their supply and demand.

Our lecturer, however, seemed to misunderstand the nature of Hayek’s argument and the sort of information to which he was referring. The lecturer sarcastically remarked something to the effect of “Do you think consumers are really well informed about the products they consume, thanks to the free market?” Surely, he seemed to be implying, the fact that most real-world consumers don’t have a full and deep intellectual understanding of every product they consume and where they come from – especially compared to the nefarious producers of those products – proves that Hayek was wrong. Thank goodness our modern understanding of asymmetrical information has superseded Hayek’s naive fantasy of consumers who are automatically kept fully informed by the magic of the market!

This is not only a misinterpretation of Hayek’s conclusions, but a misinterpretation which highlights an incorrect way of even approaching Hayek’s argument to begin with. Therefore I feel it might be worthwhile to briefly clarify what kind of information Hayek was actually talking about, in case anyone else reading this may have fallen prey to the same misunderstanding.

It is certainly true to say that consumers in a relatively free market tend to lack some information about the products they consume. Standing before the bread aisle in a supermarket, most consumers would not be able to tell you off the top of their heads the differences between the different brands of loaves, their ingredients, the companies which made them, and so forth. The same would be true for this sort of information for almost any other product and any other consumer; none of us are omniscient, and Hayek never claimed that a free price system would make us so.

However, this is not the sort of information Hayek was claiming the price system transmits. What the price system does, according to Hayek, is convey the relevant information about the supply and demand for different goods on the market, in a way that allows people to economize those goods as if they did have a conscious, intellectual understanding of those factors, even if they don’t.

To use Hayek’s own famous example, suppose that a major tin mine collapses, making the supply of tin in a given economy even more restricted than it had been before. This information will be reflected by a rise in the price of tin, and this price change will in turn affect the distribution of tin between the different producers who require it. For the producers whose tin-based products are more highly valued by consumers, those consumers will consequently be willing to pay enough for those products that the producers will still be able to sell them at a profit, despite the increased price of the tin the producer needs to buy. For other companies which make tin-based products less highly valued by consumers, those consumers will consequently be less likely to continue buying those products at the increased price, leading those companies to restrict their production of those less highly valued products, hence freeing up tin to be used by the producers of more highly valued products. In this way, the price system has conveyed ‘information’ (the fact that the tin mine has collapsed) to all relevant parties, forcing producers to economise the increasingly scarce tin in a way that sees it being channeled toward the production of the goods most highly valued by consumers.

The critic of Hayek’s theory might object that the price system hasn’t really made anyone more informed about anything, as the above-mentioned consumers and producers wouldn’t necessarily even have to know why the price of tin had risen. But that’s the whole point and the whole beauty of the system! (Indeed, in Hayek’s original argument this was what led him to the conclusion that free markets and free prices would always lead to a more preferable (from the perspective of consumers) distribution of resources than a central planner ever could, as a central planner would have to consciously know such information in order to distribute resources appropriately, whereas economic actors in a free price system are automatically encouraged to do so even without having to consciously grasp why.)

I suppose therefore it is possible, in a certain sense, to criticize Hayek’s preferred system because it does allow consumers to get by despite potentially being ignorant of certain information about the products they consume. An opponent of Adam Smith could likewise lament that, thanks to Smith’s beloved division of labour, many people today are ignorant of how to make bread, a skill which would have been indispensable for survival in previous times. However, rather than sneering at this as evidence of how the division of labour creates consumers who are too stupid to even bake bread, the correct response is to celebrate the fact that many people are now able to enjoy the delicious boon of bread as much as if they did know how to bake it, even if they don’t.

Just as with Smith’s division of labor, so too with Hayek’s division of knowledge. Far from deriding Hayek’s preferred system of free prices because not every consumer under it is perfectly informed about every product they consume, the system should be celebrated for allowing scarce resources to be distributed as if everyone knew all the information concerning their supply and demand, even if they don’t.

George Pickering is the Almoayyad Fellow in Residence at the Mises Institute this summer, and is a student of economic history at the London School of Economics.The above originally appeared at Mises.org.